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A confluence of important factors that have propelled the market
higher seem to be in the process of reversing, indicating that
the cyclical bull market that started in March 2009 is most
likely at an end. Here is the way we see it.

QUANTITATIVE EASING (QE)----Ever since the beginning of QE1, the
market has expanded when QE was in force and corrected when it
ended. Each time, the market ended its correction only when
it became apparent that there would be additional QE.
During periods when QE was on, the S&P 500 rose a total of
127%. When QE was off, the market fell by a total of about
27%. Now the Fed has given strong indications that they
would begin tapering QE over the next few months, and a survey of
investment managers and economists show that 65% think the
tapering will start with the September FOMC meeting. In
response, the 10-year note yield has soared from 1.6% to near 3%
in a short period of time, and stocks have come down from their
peak. We think that with a finite end to QE now in view,
the pressure on the market will be to the downside.

LACK OF DEMAND IN THE ECONOMY----The economy has been unable to
break out of its annualized 2% growth trend despite QE, and now
seems to be weakening further. Although recent economic
data releases have been mixed, consumer spending, which accounts
for about 70% of GDP, remains constrained by debt-heavy household
balance sheets, a tepid jobs market, barely rising disposable
income, lack of wage growth, and a low savings rate. Real
disposable income in July was down from two months earlier and up
a meager 0.8% from a year earlier. Real median household
income is at its lowest level since 1995. That is why real
consumer spending has increased only 1.7% year-over-year.

In addition the labor market is weaker than it appears.
Jobs paying wages in the lowest quintile accounted for 30% of new
jobs since the end of the recession and workers in this group
work less hours. A high proportion of new jobs involve
part-time workers who would rather work full-time, while large
part of the drop in the unemployment rate has resulted from
workers leaving the labor force. Furthermore, core capital
expenditures declined 4% in July, while the sharp rise in
mortgage rates has resulted in recent signs of weakness in
housing starts, new home sales and pending sales. Estimates
for 3rd quarter GDP growth have slipped to about 1.5%,
barely at “escape velocity”.

CORPORATE EARNINGS----Corporate earnings growth, a powerful
factor in the stock market rise along with QE, has decelerated
with 2nd quarter S&P 500 earnings growth coming in
at about 3.7% over a year earlier. Even this amount was
mostly accounted for by a 27% increase in financial earnings as
profits declined in industrials, telecom, technology, materials
and energy. Earnings estimates for the second half seem far too
high, and are likely to be slashed in coming months.

VALUATION----The market is now significantly overvalued.
Based on today’s close, the S&P 500 is selling at about 19
times trailing 12-month reported (GAAP) earnings, the high end of
the range established before the serial bubbles of the last 14
years. The long-term average multiple is about 15, with
major lows at 10 or below. Normalized for cyclicality, the
P/E ratio is 20 times.

THE COMING SHOWDOWN IN WASHINGTON----The next couple of months
will feature a showdown between the White House and Congress over
budgeting authorization and the debt limit, reminiscent of the
turmoil in 2011. Both sides seem adamant in their
positions, and are not likely to settle until the last minute, if
then. In the meantime the headlines will look pretty
scary.

TECHNICAL---The breakout of the S&P 500 above the 1687 level
reached on May 22nd petered out at 1709 on August
2nd and quickly fell back below the May high. , The
NYSE averaged about 800 new daily highs around the May top and
only 400 at the August, indicating a significant
divergence. In our view this is pointing to a major change
in market trend in response to the reversal of bullish support
from infinite QE and soaring corporate earnings as well as the
likelihood that the economy will not soon transition into the
long-awaited self-sustaining recovery.

All in all, we believe that the market is in the process of
topping out and entering a major downturn.